The Information Value of the Stress Test

Abstract

We investigate whether the "stress test," the extraordinary examination of the 19 largest U.S. bank holding companies conducted by federal bank supervisors in 2009, produced useful information for the market. Using standard event study techniques, we find that the market had largely deciphered on its own which banks would have capital gaps before the stress test results were revealed, but that the market was informed by the size of the gap; given our proxy for the expected gap, banks with larger capital gaps experienced more negative abnormal returns. Our findings are consistent with the view that the stress tests produced valuable information about banks.JEL codes: G14, G18, G21

Evaluating the information in the federal reserve stress tests

“…Thus, disclosure of stress test results appears to affect the value of all large BHCs. Some of our results are similar to those reported by earlier researchers (Morgan et al 2014 for SCAP, Candelon and Sy 2015 for SCAP through 2013), despite differences in our return generating functions.…”

“…As in previous studies (Petrella and Resti 2013, Morgan et al 2014, Candelon and Sy 2015, Bird et al 2015, we find statistically significant average cumulative abnormal returns (CARs) for stress tested BHCs around many, though not all, of the stress test disclosure dates. Also like previous studies, these average CARs are sometimes positive and sometimes negative, suggesting that simply averaging positive and negative abnormal returns in a standard event study could obscure the impact of stress test disclosures.…”

“…7 (Campbell, Lo andMacKinlay 1997 andKothari andWarner 2006 provide overviews of event study methodology). This specification differs from those used in earlier studies (Morgan et al 2014 and Candelon and Sy 2015), which use a banking stock index or simple market model. We estimate the three factor market model using daily returns over a 6 month window ending on the last day of the month prior to the event date (e.g.…”

“…Previous authors have studied market reactions to stress test announcements (Morgan et al 2014, Petrella and Resti 2013, Candelon and Sy 2015, Bird et al 2015. They have found mixed evidence of whether banking firms experience significant abnormal average stock returns when supervisory stress test results are disclosed.…”

“…Morgan et al (2014) examine the stock price reaction for bank holding companies involved in the 2009 SCAP and find positive cumulative abnormal returns that vary in relation to each BHC's capital "gap" (that is, the amount of capital needed for each BHC's stressed capital ratios to meet minimum target levels). In particular, the results suggest that abnormal returns were lower (more negative) the larger the difference between the capital gap calculated in the stress test and ex ante expectations of the gap, consistent with the idea that the stress tests provided new information about the extent of capital shortfalls at these firms.…”